The Reason Why Americans' Debt Is Falling Is That People Are Defaulting Like Crazy

Vincent Fernando, CFA

Sep. 29, 2010, 7:16 AM

American households are cutting back their debt so rapidly that debt payments as a percentage of disposable income has hit about a nine-year low. Yet there's more to this national deleveraging than belt-tightening.

Total household debt fell by $77 billion during the three months ending in June, but nearly half of that decline stemmed from bank charge-offs of residential mortgages, credit cards and other consumer loans, according to Capital Economics Group. In a recent report, the London-based economic research consultancy found that this isn't necessarily a new development. Household debt has fallen every quarter since the beginning of 2008, leaving it $473 billion below the peak, which is the equivalent of reducing debt at every household by $4,200.

Here's where it gets strange:

Shedding away debt - however it's done - is critical to the overall health of the economy. But the wave of households de-leveraging by default is worrisome. And many Americans are using their new savings to buy up U.S. Treasuries instead of devoting it all toward paying down debt. During the past year, households bought 42% of the new Treasury debt issued, equal to about $616 billion and far more than the $432 billion absorbed by foreign investors.

This is a typical example of investors' propensity to mentally compartmentalize their financial life into different 'buckets', despite the fact that what ultimately matters is the complete sum of our financial positions.

Thus if you happen to be included in the above, then by all means pay down debt completely before buying U.S. treasuries. Else you're losing money on the spread between the yield you earn on your government bond and the surely higher interest rate you pay on your debt outstanding. Savings aren't savings when you have a loan outstanding that nets against them.